How High Can NetEase Fly?

Shares of NetEase (NAS: NTES) hit a 52-week high on Thursday. Let's take a look at how it got there and see whether clear skies are still in the forecast.

How it got hereThe global gaming industry is going through a major shift as content is being moved online from traditional gaming platforms. That's got big implications for both Activision Blizzard (NAS: ATVI) and Electronic Arts (NAS: EA) . Activision has a boot in each camp, whereas EA focuses more on console games.

But it's great news for NetEase, which offers online multiplayer role-playing games that are all the rage among China's youth. In NetEase's latest quarter, online game revenue grew by 31.4%, handily outpacing ad revenue growth of 13.1%. That simply means word-of-mouth and the company's core line of games is doing most of the work of bringing new customers in.

Also favoring NetEase shareholders was China's decision yesterday to ease its lending rate for the first time since 2008. The move, which was undertaken to stimulate China's economy, could spur business growth, which, in turn, could add to NetEase's already robust profits.

NetEase won't, however, be without its own challenges. Cranking out one hit after another is very difficult. There's also a significant level of competition internationally from EA and Activision, as well as domestically from SINA (NAS: SINA) and Perfect World (NAS: PWRD) .

As you can see, NetEase has dramatically outperformed traditional gaming platforms, the erratic Perfect World, and even the more diverse SINA over the past five years.

Company

Price/Book

Price/Cash Flow

Forward P/E

5-Year Revenue CAGR

NetEase

3.7

12.0

12.3

27.5%

Electronic Arts

1.7

16.3

10.4

6%

Activision Blizzard

1.2

13.9

10.9

25.7%

SINA

3.3

54.7

42.3

17.8%

Perfect World

0.8

2.7

2.7

97.2%

Source: Morningstar, author's calculations.

Now before you get giddy and go buy the entire sector because of the huge five-year sales gain, let me do some explaining.

Perfect World, if we can trust management's ever-changing guidance, was only getting off the ground in 2006 and thus averaged a near-doubling in revenue since then. In recent years, growth has slowed and its recent earnings history has been wildly erratic, but it is nonetheless very inexpensive.

Activision Blizzard's figures also come with an asterisk as they greatly benefited from the merger of Activision and Blizzard in 2008. The company has benefited from owning the online sensation World of Warcraft franchise.

Electronic Arts has had some trouble with its packaged games. Its latest quarterly results fell short of the Street's estimates, causing the company to join Activision Blizzard in announcing job cuts to cut expenses.

SINA, as previously mentioned, offers online gaming in China, but is primarily driven by its advertising revenue and its Facebook/Twitter hybrid, Weibo.com. Recent quarters have shown a rapid rise in operating expenses associated with Weibo, so that would be why its valuation is much higher than its peers'.

Finally, NetEase has been growing with regularity and is as close as you'll get to an online-only gaming pure-play. If there was one concern, it'd be that gross margin, though up in its latest quarter, has tapered off in recent years as expenses have risen.

What's nextNow for the $64,000 question: What's next for NetEase? That answer is going to depend on whether it can keep its operating expenses under control and whether it can convert email and free members into paying members.

Our very own CAPS community gives the company a four-star rating (out of five), with an overwhelming 96.5% of members who've rated it expecting it to outperform. As should not surprise you by now, as a noted contrarian I'm one of the few members who have anointed NetEase with a CAPScall of underperform and am currently down 38 points on that call. While this is painful, I have no intentions of closing the pick.

There are two main reasons I feel NetEase will underperform going forward despite its strong sales growth and reasonable valuation. First, development costs to create new games are huge, and if what Electronic Arts' vice-president Jeff Brown has said is correct, then development costs could rise by as much as 200% for next-generation games. Secondly, gross margin deterioration of NetEase's peers SINA and Sohu.com can't bode well for the overall health of the gaming industry in China. Although margins rose in its latest quarter, I remain skeptical about the downtrend.

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At the time this
article was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of Activision Blizzard and Facebook, and has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of NetEase, Activision Blizzard, SINA, and Sohu.com, as well as creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.